Can Nonresident Aliens Be Excluded From Deferring in 403(b)s?

“We are a private health care organization which sponsors an Employee Retirement Income Security Act (ERISA) 403(b) plan. Can we exclude nonresident aliens from the right to make elective deferrals to our plan?”

Stacey Bradford, Charles Filips, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

The Experts are glad you asked this question, as this is a common area of error in administering the universal availability requirement for 403(b) plans. Many plan sponsors subject to that requirement erroneously believe that they can exclude ALL nonresident aliens from the right to make elective deferrals when, in reality, they often cannot exclude ANY nonresident aliens from the right to make elective deferrals.

Let’s take a look what the Internal Revenue Code says here. Section 403(b)(12)(A)(ii) provides that “…there may be excluded any employee who is a participant in an eligible deferred compensation plan (within the meaning of section 457) or a qualified cash or deferred arrangement of the organization or another annuity contract described in this subsection. Any nonresident alien described in section 410(b)(3)(C) may also be excluded…”

So now we need to look at Section 410(b)(3)(C), which provides that “…employees who are nonresident aliens and who receive no earned income (within the meaning of Section 911(d)(2)) from the employer which constitutes income from sources within the United States (within the meaning of Section 861(a)(3)).”

Section 911(d)(2)(A)’s definition of earned income is fairly straightforward:

“[T]he term ‘earned income’ means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.”

The definition of earned income under Section 911(d)(2)(A) generally corresponds with the traditional definition of wages under Section 3401(a). It turns out that, for the most part, income from sources within the United States under Section 911(d)(2) is fairly straightforward as well—generally it is income earned while working in the United States (commonly referred to as “U.S. Source Income”).  However, Section 861(a)(3) excludes from U.S. Source Income compensation paid for personal services performed in the United States by nonresident aliens who are (a) present in the United States for a period not exceeding 90 days during the taxable year, (b) paid less than $3,000 during the taxable year for their services, and (c) performing services for a nonresident alien or a foreign entity; or performing services for a U.S. entity or resident if such services are performed for an office or place of business maintained in a foreign country; or performing services in connection with a temporary presence in the United States as a regular crew member of a foreign vessel engaged in international transportation.

As such, a nonresident alien will likely have U.S. source income unless they are in the U.S. on a very short term basis (less than 90 days) and are paid less than $3,000 for their services during the taxable year. Thus, for most 403(b) plan sponsors, nonresident aliens performing services in the U.S. must be allowed to make elective deferrals to a 403(b) plan. If the nonresident alien is NOT employed in the U.S., he/she may be excluded, but this is not a common scenario among entities that sponsor a 403(b) plan.

Now, just because nonresident aliens CAN make deferrals to a 403(b) plan doesn’t necessarily mean that they SHOULD defer. Due to their special tax circumstances, and the fact that such employees are generally not in the U.S. for a period long enough to derive a benefit from saving in a retirement plan, many such employees may not elect to defer even if given the opportunity. However, absent another exception to the universal availability rule, they must generally be given the opportunity to make elective deferrals to a 403(b) plan.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.